Small investors often make poor investments

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Published on Tuesday, 06 May 2014

Inexperienced investors often fail to make wise investments because they are too influenced by psychological and sociological “biases” rather than economic fundamentals. So called “mum and dad investors” mistakenly think they are doing the right thing by selecting a wide range of shares from famous firms and by following media tips.

“However, unsophisticated investors tend to be too influenced by short-term events to assemble a share portfolio which will maximise returns,” commented Dr Annica Rose, a post-doctoral researcher at the Luxembourg School of Finance, the Department of Finance at the University of Luxembourg.

Annica Rose divided stocks on the Helsinki Stock Exchange into different groups according to their popularity for smaller investors. She then tracked their performance over the next three years. In the initial three-month period, popular “mum and dad” stocks often had better returns than the less popular ones. However, after six months this switched around, with the less traded stocks performing worse and continued to do so. These findings have been published in the leading academic journal Review of Finance in the article Systematic Trading Behavior and the Cross-Section of Stock Returns on the OMXH.

“If a big company releases a new product or is running an impressive advertising campaign, this tends to sway the retail investor,” noted Dr Rose. “Alternatively, they may see a stock’s price rising and decide to jump on.” However, often in just a few weeks the fundamentals of supply and demand assert themselves and the price will revert.

Behavioural economists have highlighted a range of biases by small investors playing the market. For example, it is very common for “mum and dad” to sell profitable stocks too early, missing out on large long-term gains. Conversely, people are often unwilling to cut losses on badly performing investments. Dr Rose’s contribution is further evidence to suggest that when making major, long-term investments it pays to do some cool-headed research or rely on the professionals.